Financial investors value a firm based on the direct cash flows arising from the investment (e.g., in the form of dividends and capital gains). Strategic investors are those who derive additional expected cash flows from the investment in the firm (for example, the products of the firm can enhance their own product offerings marketability), or investors whose investment brings additional value to the firm (in terms of reputation, sales capabilities, etc.). Companies are typically worth more to strategic investors than to financial investors. On the other hand, the value of one investor to the company may be higher than the value of another investor. Therefore, although the company's value to a particular investor may be higher, the company may agree to an investment by another investor according to a low value since such investor is expected to better enhance the company's value than other investors. The company must always remember that its goal is to raise its value over the long run and not in any specific round of investment. The reasons for a company's being worth more to some strategic investors than to financial investors are varied starting with the fact that the company's customer base could be better exposed to sales of other products by the strategic investor and ending with the possibility that the products developed by the company in which the investment is made will fit into the mosaic of products manufactured and offered by the strategic investor to its own customers.
Let us assume, for instance, that Radio Ltd. has developed an algorithm for compressing vocal information which makes it possible to broadcast to a thousand listeners at a bandwidth required by other technologies for broadcasting to a single listener. The value of the company will naturally be derived from the fact that it opens up possibilities to save substantially on broadcasting costs and to expand the station's audience without changing its infrastructure. However, obviously such or another type of cooperation with one or more Internet radio station infrastructure suppliers will raise the company's value considerably, since it will enable an integration of the product into the products of the infrastructure manufacturer.
Real Networks, which sells infrastructure for radio stations, will be interested in purchasing the company (or investing in it) in order to improve its ability to benefit from the company's developments and to influence the company not to cooperate with its competitors. Therefore, the company's value to the infrastructure manufacturer is higher than its value to other investors, and the value of the manufacturer as an investor is higher from the company's standpoint than the value of many other investors. Without going into the expected results of the negotiations between the parties which may be forecasted according to the competitive positions of Real Networks and Radio Ltd. Radio Ltd. obviously has a weighty interest not to frustrate the investment negotiations, although the company would possibly be better off by signing a cooperation agreement without an investment (since such an investment could "label" the company vis-à-vis other potential partners, for example, Microsoft).
Components in the Value to Strategic Investors and Buyers
An extreme case of valuation for strategic investors is the case of valuation by a strategic buyer. The value of a company to strategic buyers is the company's value to a financial investor (namely, its value as an independent company), plus the value of the synergy between the company and the strategic buyer, minus a component representing the independence value which will be lost as a result of the acquisition. In the example given above, if Radio Ltd. is bought out by Real Networks, the chance that stations using competing technologies will use Radio Ltd.'s products will clearly decline. However, integrating Radio Ltd. into Real Networks may increase the growth rates of Real Networks, thus considerably raising its own value.
Historically, companies which buy other companies tend to overvalue the synergy with their business, as is visible from the market reactions to announcements of such acquisitions. Companies which declare substantial acquisitions usually suffer a neutral or negative market reaction. This phenomenon is prevalent mainly in industrial sectors in which a slight change in growth rates does not materially affect the value of the company. In high tech or fast-growing industries, the "defensible" synergy component is larger, and payments reflecting a high acquisition premium in proportion to the value of the company to financial investors are therefore more likely.
The Importance of Potential Strategic Buyers to Financial Investors
Strategic investors each make individual specific estimates of a company's value to them. However, when valuating a company, it is desirable and even essential to try to estimate the possibilities of exiting the investment via an acquisition. In the late 1990s, more than five acquisitions of high tech companies took place for every IPO. This figure clearly reveals the importance of a valuation of the company to potential buyers.
Statistical data of acquisitions in related fields, which usually indicate the various multiples according to which acquisitions were made, may facilitate an estimate of the company's value to strategic buyers. For instance, many independent Internet Service Providers (ISPs) in attractive locations are valued according to the value-per-subscriber in similar acquisitions, and not the value-per-subscriber of public companies. One of the reasons for this is that this field is highly sensitive to economies of scale, and using the value-per-subscriber of public companies could therefore lead to unreasonably high values.
When there are not many potential buyers, separate valuation should be made of the companies which may purchase the company, in an attempt to assess the effect of an acquisition, if made, on their value. Let us assume that the value of Real Networks will rise by $100 million if it were to buy Radio Ltd. In such a case, it may be expected that the maximum price which Real Networks would be prepared to pay for Radio Ltd. would be this amount, if it does not fear the damage it may suffer if Real Networks' greatest competitor, Microsoft, buys Radio Ltd. If Real Networks is convinced that Microsoft will buy Radio Ltd., as a result of which Real Networks' own value would decline by $50 million, then the maximum price which Real Networks would be prepared to pay for Radio Ltd. would rise to $150 million, since the acquisition would increase its value by $150 million as compared to a situation in which Radio Ltd. is bought by Microsoft.
After assessing the company's added value to potential strategic buyers, the probabilities of such a scenario materializing should be assessed and priced according to the value to financial investors. It should always be kept in mind that exiting an investment via an acquisition provides a cash flow to the financial investor, which is similar in nature to cash flows obtained by him or her from the company through other channels (such as dividends or sales of his or her shares following an IPO), but with a different risk profile.